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Mutual Funds Quarterly

Gems in the Ruins

By

Sandra Ward

Updated Jan. 11, 1999 12:01 a.m. ET

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A n Interview With Arnold Schneider ~ A favorite of institutional investors since his days as a partner with Wellington Capital Management, Schneider has always had a special knack for selecting obscure and unloved small-company stocks just before they begin to realize their potential. It's a gift that has led some, notably friend and fellow money manager Ted Aronson of Aronson Partners, to call him an "artist." The 37-year-old Schneider earned such accolades after a nine-year streak of beating the S&P 500 while at Wellington. It's easy to see why fireworks ensued when he left two years ago to start Schneider Capital Management in Wayne, Pennsylvania, a suburb of Philadelphia. Wellington waged a lengthy -- and eventually successful -- legal battle to keep formidable clients such as RJR Nabisco Holdings, Frank Russell Co. and the Utah State Retirement Board from defecting to Schneider, a measure of how highly he's regarded in the business.

Much of the press Schneider's gotten of late focuses on the now-famous lawsuit. We thought it was high time someone asked him about his stock picks, especially since he launched the Schneider Small-Cap Value fund in early September. Since inception, aided by a mini-revival in the small-stock sector, it's up about 35.3%, he says. Read on for a glimpse of the artist at work.

Barron's:What is it about what you do that everybody wants a part of?Schneider: In many ways, we are traditional value managers and we look for low-P/E stocks and compare their P/Es to their earnings growth. If we do anything differently, it's that we insist that our companies are about to experience fundamental improvement. It could be something relating to the industries they're in; you know, a paper industry where pricing is getting better. Or it could be a new management coming to turn a company around.

Q : How do you sense change is afoot?A : That's the art, I guess. If it's an industry, you can go through supply and demand, or look at some kind of change in the economics, such as a pickup in market share. It's a sense of having experienced a lot of these cycles with different companies. It's a sense of things coming together -- if companies leave a business or close capacity or you figure prices can't get any worse. More obviously, within companies, you can see a new CEO. You can see a new president of a division that's troubled. You can see a new product cycle beginning. So we are looking for something that is going on. We figure if things get better, the stock market is going to figure it out.

Q : You just launched a small-cap value fund in September and, so far, your timing looks splendid. Should we assume you see a change in their fortunes?A : Part of the reason that we set up the fund is the incredible divergence in valuations between the small-caps and the large-caps, particularly small-cap value stocks. Although those divergences have existed for several years, they are at their widest right now. Second, relative earnings growth is starting to favor small-cap stocks as the mega-caps are finally starting to experience slowing growth. Third, a Fed cut historically has been the catalyst to sparking the small-cap cycle. Rate cuts lead to increased economic growth, which gives people confidence in small-caps. When the Fed is cutting rates, people also feel more comfortable going into "riskier securities" like small-caps or emerging markets, frankly. We've had not just the U.S., but pretty much the entire world cutting rates in the past three or four months, so it's a global phenomenon. All those factors combined will be what gives us a small-cap cycle again after five or six years of drought.

Q : What about liquidity concerns?A : You are seeing some small-cap funds opening up. In the institutional world, pension funds are increasing their weightings in small-cap funds. There is more interest, precisely because the sector's results have been so poor; we're at record underperformance. Like anything else, when it starts to go, people will pile in. Pension funds see really cheap stocks here. These are good companies. You have to ask: "Why should these be selling at a 40% P/E discount to the large-cap stocks?" That's way too wide. But the interest level is clearly up. That will help push up small-caps. Because they are such a small part of the U.S. market now, any minor shift toward them can have an exaggerated influence.

Q : Can you think of any other period in which there was a similar divergence between small- and large-cap values?A : Well, 1973 would be similar, not only because of the divergence, but also because of the very heady absolute valuations that exist in the mega-caps, the S&P 500, if you will. They are selling for 26 times 1999 earnings. These companies are in some pretty mundane businesses, and they are so big they can't grow much faster than the industries they're in.

Q : That hasn't stopped some people from buying them!A : As long as the earnings come through, people keep bidding them up. But when they blow up, it's going to be ugly. All the friends will be gone and the stocks will be down 40% or 50%. That's the risk, they work until they don't work.

Q : So, what's your outlook for the coming year?A : Well, it's pretty hard to be bearish with the Fed at our back. But with valuations so high, I guess it's also very hard to see how the market is going to have another big year, after so many in the past five or six years. So I would kind of look for a more normalized 10% type of year, with small-caps finally outperforming, because of the factors we mentioned.

Q : Do you worry about deflation?A : Well, I do view inflation as a cyclical phenomenon. It is unlikely that we are in a permanent deflationary environment. The CRB and the other commodities indexes are basically trading at major bottoms, based on the past. If you look at the individual components, it is very difficult to see major downside in almost any commodity. People in almost every major commodity are losing money. The high-cost producers are losing money, whether it's in hogs or grain or oil and, obviously, all the metals. It's really an unsustainable period. There were 60 interest-rate cuts last quarter around the globe, so unless they repeal basic economics, those are going to have an impact in about six months. I don't think commodity prices can stay here, and I think we will see a re-acceleration in global demand.

Q : I haven't pinned you down on market cap. How do you define a small stock?A : Basically, where the Russell 2000 and 1000 diverge is how we define it. To us, a small stock is anything under $1.5 billion in market cap.

Q : Do you hang on as they grow to mid-caps?A : Yes. Only at purchase does the stock have to be small. We have one stock,
Arrow Electronics
, which is now mid-cap. We won't own it forever. But it's stupid to just sell it.

Q : You seem to pay special attention to liquidity and trading costs. Does that mean you'll close your fund at some point?A : For liquidity reasons, we think we'll close all our small- and all-cap products when we have a total of $1.5 billion in small-caps in all of them combined. We're at about $300 million.

Q : How much foreign exposure can you have in the small-cap sector?A : Up to 10% or so. And we are probably pretty close because of what has gone on with the foreign markets. But that's higher than we would typically own. We don't usually bounce up against that 10% too much.

Q : Do you favor any particular sectors?A : We're primarily stockpickers and our approach is bottom-up. We are finding a number of small-cap companies below 10 times 1999 earnings. They have tremendous upside potential as their earnings and P/Es expand. We are finding lots to buy in small-caps. If we were to identify one sector that looks interesting it would be HMOs. We like them a lot. We treat them as a package. Three small-caps in that area that we own are
Foundation Health Systems
,
Coventry Health
and
United Wisconsin Services
.

Q : Any other industry picks?A : We're interested in what we call commodity semiconductors because of basic supply and demand issues: There are no new fabricating plants being built in the world, because the entire memory sector is losing about $10 billion on an annualized rate. Or was until very recently.

Q : But isn't that because they built too much, too fast?A : Yeah, it's just been brutal, absolutely brutal, and the Koreans, the major transgressors, really had their legs cut out from under them in the financial crisis. So everyone has been cutting back capital spending dramatically. However, we see signs of price and margin improvement in the memory area, as unit growth surges. And the two stocks that we own in the small-cap fund that should benefit are both SRAM [static random access memory] companies,
Integrated Device Technology
and
Cypress Semiconductors
. Both stocks sell for about seven times their normalized earnings power, which we see coming probably in the year 2000. So, they are very cheap.

Q : What other sectors do you like?A : Another would be paper. Barron's actually did a very good article on the subject recently. Globally, the industry will add the smallest amount of new capacity in two decades over the next couple of years. And prices in almost every grade are at the cash cost of the high-cost producers, so they're unlikely to fall much further. As the global economy perks up just a little bit, this industry will begin to experience positive unit growth and pricing power, especially given the permanent closures that have been announced in a couple of the major grades because of mergers. There are a number of stocks we like here. One is
Mercer International
, a German pulp producer with very low wood costs. Right now, at the trough of the cycle, it's earning $1 a share. We think it could earn $5-$6 at the peak. They have little net debt, huge tax-loss carryforwards and terrific management.

Q : Doesn't it have some horrendous labor costs to contend with?A : No, the company is actually a low-cost producer, and its managers are dealmakers. Besides having low wood costs, they were able to buy assets on the cheap. At $6 a share, the stock is at six times trough earnings. It trades over-the-counter here. I think one guy on Wall Street follows it. It is just an incredibly cheap company. We basically buy it every day, and nobody knows about it.

Q : They do now! Any others?A :
Longview Fibre
. Very simply, it's a $10 stock and its net asset value, most of which is timberland, is over $30 a share. It's purely an asset play. They make linerboard -- they are actually a high-cost producer of linerboard -- but that's really a small part of the story. When you can get something for one-third the price, it's just a giveaway.

Q : Give us more.A : The third one is
Gaylord Container
, which has some very good linerboard assets. Its asset value is $15 a share, and the stock changes hands at 6. We think they'll earn a $1 a share in 2000. And that's not peak. Peak earnings would be $2.

Q : How long till it hits the peak?A : It's not unlikely that they will reach the peak in 2001.

Q : Gee, for a stockpicker, you like a lot of sectors.A : Now, it's on to special situations. There's a duo that I will mention together, because they are basically the same companies. We own a pair of Canadian hotel real estate investment trusts, one is
Legacy Hotels
, owned partly by
Canadian Pacific
, and the other is
Canadian Hotel Income Properties
. The Canadian hotel industry is where the U.S. hotel industry was three years ago: There is absolutely no new supply coming on. With the very cheap Canadian dollar, tourism is very strong. So "Revpar" -- the industry acronym for revenues per available room -- is growing more than 5% per year. And the two stocks are both selling at about half of replacement value.

Q : Meaning? A : Meaning you can buy all these securities for half the price it would cost to build a new hotel. Canadian Hotel is selling at a 16% yield. Legacy's yield is 12%. Based on FAD, or funds available for distribution, the gross cash flow minus the capital spending for maintenance, the stocks are very cheap. FAD is a more conservative number than FFO or funds from operations, which is just gross cash flow. Canadian Hotel trades at 6.3 times FAD; Legacy, at 7.3. Those numbers aren't that different from the hotels in the U.S. But in the U.S., revenues per available room are going down, occupancy rates are going down and new supply is coming on. That's why
Starwood Hotels & Resorts
is having trouble. We owned Starwood three years ago, when things were good. We later got out. In Canada, things are going well and the direction is upward, so they should not be selling at these types of multiples, which imply there are troubles to come.

Q : Would we want to stay in a Legacy or Canadian Hotel room?A : If you go to the big cities in Canada, these are where you would have your wedding if you were rich and didn't have a private club or something. The Royal York in Toronto is owned by Legacy, for example.

Q : Have these hotel companies been hurt by the problems in Asia?A : They each have a hotel in Vancouver and that's been soft, but everywhere else has been strong. Revpar is growing 5%.

Q : Are the Americans picking up the slack at all?A : The Canadian dollar is so cheap that tourism is strong. In the Eastern part, where the Americans go, tourism is great.

Q : Do these stocks trade on Canadian exchanges?A : Yeah, that's one of the reasons they're cheap. That always inspires a discount. That's the hotel story.

My next pick is
Metromedia International
, run by two great managers, John Kluge and Stuart Subotnick. It's the same name as Kluge's old Metro Media that he sold to LDDS Communications, which is now part of MCI Worldcom.

Q : What's its focus?A : It's an emerging-market portfolio of telecommunications and wireless companies. Basically, Kluge has bought up licenses and properties in cellular, paging, cable and basic telecommunications -- that is, long-distance -- in Eastern Europe and in Asian emerging markets. A lot of them are joint ventures, and some are wholly owned. And the stock trades for about $3 a pop, or potential customer. With a U.S. companies, you pay $200-$300 a pop. There are no competitors in a lot of these areas, so they have the only cellular license, the only paging license or the only cable. In many areas, some of these technologies aren't competing with basic phone service; they are the phone service. Nonetheless, the stock trades for about one-third of its net asset value. And it's growing at about 20%-30% a year.

Q : Is there a lot of capital spending related to this?A : Yes, clearly. They have net cash on the balance sheet of $2 or $3 a share, which will fund their growth through at least the end of 1999. They also have a hidden asset. They own Snapper, the lawnmower company -- an unrelated business they could sell. So, it is a good balance sheet.

Q : How much of your interest in this is based on the company's management?A : A lot. John Kluge has been a pioneer. He basically figured out paging and cellular in the United States before anyone else did. I think that is the opportunity he sees here, that there haven't been a lot of people competing for these licenses. Stuart Subotnick has been his right-hand man with the old LDDS. So they've worked together, and we think they're superb managers. Some of the individual divisional managements are excellent, as well. So it goes beyond the two of them.

Q : What are some of the countries Metromedia is in?A : They are in China. Eastern Europe is probably their biggest focus. They have a great radio license in Berlin.

Q : How do you value this?A : The stock has been trading recently at about 7. But its NAV is probably 20.

Q : Next name, please.A :
Intertan
. This is the international Tandy Corp. It actually spun out of Tandy. The stock recently was 5 and change. Our earnings number for calendar 1999 is 80 cents. Book value is over $7. They have a huge tax-loss carryforward in the U.K. So it is very cheap. But their comps are growing at a double-digit pace in all three countries they are in -- Canada, Australia and the U.K. And it is a turnaround. Management came in and refocused it, and comparable-store sales versus those a year earlier have been strong for a while. Normally, you get double-digit comps and the market starts selling for 40 times earnings. You can get one here for six times earnings and no one cares.

Q : What do they sell?A : Electronics, cellular and satellite dishes.

Q : Do they have much in the way of competition?A : The U.K. is tough. There are very good competitors there. Less so in Canada and Australia.

Q : Shoes?A : That's the first thing people think of, but the shoes are kind of a little annuity business. The real driver is Casual Male Big & Tall stores, a men's clothing chain.

Q : You shop there?A : No. I have gone in there just to check around. They kind of look at me funny. I think my brother might shop there!

Q : What's to like about this?A : This guy Stuart Glasser came in 1997 and sort of re-merchandised the stores. They have also remodeled the stores and they've been making good progress. The stock was absolutely crushed with the warm fall, because they have a lot of coats. And we think there is $1 worth of earning power for the company when this restructuring of Casual Male takes full effect. For 1999, we still think they will do 60 cents. So it's a giveaway on 1999 earnings. This stock is also under its book value of about $6.

Q : What are the demographics? Are men getting bigger? Taller?A : People are getting bigger. It is really a nice niche. Basically, if you go to a department store and you are big or tall, you really don't get much selection. At Casual Male, the assortment is wider and deeper, if you will. They serve a function. And they are really one of the few nationwide companies focusing on this.

Q : Any other names?A : I have three more. One is
Ocean Energy
, which is merging with Seagull Energy. In the past few months we've overweighted energy stocks, particularly natural gas, but oil's cheap too. U.S. natural-gas production is slipping at the same time the industry is experiencing secular growth in the 2%-3% range. That should provide price support. Ocean Energy has tremendous exploration activities in West Africa and great acreage. Seagull gives them natural- gas reserves. Cash flow is about $2.60 a share. It's not just an asset play; its operations are close to breakeven, and the merger gives them big cost savings.

Q : Two more to go.A : Next up is
Unisource Worldwide
. They and International Paper dominate the paper-supply distribution business. The company has new management that is centralizing operations and that has dramatically cut its cost structure. The stock is selling for about eight times 1999 earnings and five times 2000 earnings, when the restructuring should be completed. It's a great cash-flow business.

Q : How much of the market do they have?A : They and IP both have about 18%. And the next biggest player has 3%.

Q : One more.A : The last one is
R.G. Barry
, the top slipper company in the world.

Q : Slippers?A : Dearfoams. Did you get any for Christmas?

Q : I hate to say it, but it wasn't on my list. What's the appeal?A : It's a cheap stock. They are going to earn $1.40 in 1999. They have $4 a share in cash on the balance sheet and a 70% market share in the U.S. But it's not just another cheap small-cap. The company is going into Europe for the first time. It's expanding with Wal-Mart. They started in France and that's gone very well. There's huge potential. But the real home run is this: R.G. Barry has patents on a lot of heat-retention and thermal products and they have applied them to the pizza business. To keep pizzas warm, Domino's uses a box made by a competitor to R.G. Barry. Domino's is rolling it out nationwide, promising that your pizza will be piping hot when it's delivered to your house. In the winter, I hate getting delivery. Half the time, the pizzas are cold. Domino's is really basically branding this into its delivery services and making a big deal about it on TV. And its pizza sales in the parts of the country in which they've already rolled out this device are going way up. So Pizza Hut and Papa John's have to respond. And R.G. Barry has the patents.

Q : But who's to say the company that made the pizza warmers Domino's contracted with won't win out?A : Barry lost out because it didn't want to sign an exclusive agreement. No. 2, Barry has the patents. In fact, it's suing the company Domino's is using. Barry already has a contract with a modest-size regional chain in Columbus, Ohio. And I think it will hook up with Pizza Hut or Papa John's. This is a small company, so that kind of deal could have a big effect. This is the potential home run.

Q : I see a pattern emerging here. You pull on your slippers to pad to the door to get your pizza. Soon, you'll be shopping at Casual Male!A : There you go. Again, it's a great little company on its own. Selling for eight times earnings, which are rising at double-digit rates with the expansion in Europe. But the pizza warmer can provide the real sex appeal to get the stock going. It could add 20 or 30 cents a share in earnings in a year or two, if they got one of these contracts.

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